Optimal Interventions in Markets with Adverse Selection

Abstract

We characterize cost-minimizing interventions to restore lending and investment when markets fail due to adverse selection.We solve a mechanism design problem where the strategic decision to participate in a government's program signals information that affects the financing terms of non-participating borrowers.In this environment, we find that the government cannot selectively attract good borrowers, that the efficiency of an intervention is fully determined by the market rate for non-participating borrowers, and that simple programs of debt guarantee are optimal, while equity injections or asset purchases are not.Finally, the government does not benefit from shutting down private markets.

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